Lingering Flaws in Financial System Revive Fears of Depression

Treasury watchdog Neil Barofsky's report on the failure to secure favorable terms for taxpayers in the 2008 bailout of AIG brought a hailstorm of criticism
on Timothy Geithner, then the head of the New York Fed and currently the U.S.
Treasury Secretary. But after digesting the report,
economists are looking beyond the particulars of the AIG bailout to the
broader problems it reveals about the financial system, and the administration's failure to cope with them.

5% Chance of Great DepressionBrad DeLong worries
about the possibility. "[I]f such a shock hits, the U.S. government
will be unable to do a d----- thing about it," given its inaction.

We could cushion the impact of another big downward shock by
recapitalizing the banks again. But the failure of the Fed and the
Treasury in the aftermath of Lehman to grab a share of the upside from
its capital injection and purchase operations for the public in the
form of warrants means that there is no coalition anywhere for a repeat
or anything like a repeat of propping-up the banking system: the right
thinks it is an unwarranted intervention in the free market, the left
thinks that it is a giveaway to the undeserving and feckless superrich,
and the center is bewildered because it is an enormous and
poorly-structured intervention in the market, it is a giveaway to the
undeserving and feckless superrich, and the optics are terrible.

'Biggest Danger America Faces' The Washington Post's Ezra Klein says it's Congressional inaction due to political concerns. "The issue isn't that some storm will unexpectedly slam into the
economy and there will be nothing anybody can do, but that the storm
will hit and Congress will choose to do nothing.
The biggest danger America faces is not rising health-care costs or
global warming or the budget deficit. It's the political system's
inability to act on these issues, even though the solutions are
generally quite clear."

The Lost Decade The New York Times' Paul Krugman laments
the erosion of public trust. "I think the bigger cost is that we’ve
greatly increased the chance of a
Japanese-style lost decade, with I would now give roughly even odds of
happening. Why? Because bank-friendly policies have squandered public
trust in all government action: try talking to the general public about
stimulus, and it’s all confounded in their minds with the deeply
unpopular bailouts," he writes. But the truth is that "Big financial
institutions are a small club, with a shared interest in sustaining the
system. [...] Individual banks are in a long-term relationship with the
public and
the government. They have an interest in preserving that relationship."

'Putting Out The Fire' Felix Salmon sympathizes
with the Fed, which has been criticized for spending lots of money to
save AIG from its own irresponsibility. "The government was also
battling a major crisis using the only weapon
at its disposal: enormous amounts of liquidity. When you’re putting out
a fire, you don’t stop to worry that large amounts of liquidity are
going to end up where you don’t particularly want them — the important
thing is putting out the fire. So yes, given a bit more aggression and
foresight, the Fed could have
tried to cram down a haircut onto AIG’s counterparties. But at the
time, no one was particularly interested in being harsh to the global
financial sector; instead, they were trying to rescue it."

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